Student Loan Interest Deduction – Savings or Scam?

It's almost tax time, and if you're a college student or young adult, one of the most common tax deductions that you receive is the student loan interest tax deduction.

And even more so with all the dialogue going on in Congress with reducing or eliminated this deduction - what will happen.

The real bulk of the argument is this: is this tax deduction actually helpful, or does it encourage poor behaviors?

Let's look at whether the student loan tax deduction is really helpful savings, or more of a scam...

Student Loan Interest Deduction

You can deduct up to $2,500 of student loan interest that you paid.  The great thing about this deduction is that it is an adjustment to income, so you don't have to itemize.  This is very helpful for young adults and college students, since many of them don't itemize.

You can claim the student loan interest deduction if you meet the following criteria:

• You paid interest on a qualified student loan
• You are legally obligated to pay interest on that student loan
• Your adjusted gross income is less than $80,000, but phases out starting at $65,000 (or $160,000 if filing jointly, but phases out starting at $130,000)
• You cannot be claimed on someone else's return

You can read more on the specifics in IRS Publication 970.

The Benefits of the Student Loan Interest Deduction

Like all deductions in the tax code, the goal is to incentive something.  In this case, the goal is to incentivize education, by making it more affordable for individuals to get student loans to pay for their education.

Here's the premise.  If you want to get a higher education, and you can't afford it, you don't have many options.  You can check out my Student Loan Debt eBook for more information, but your main option is going to be student loans.

Since you have to get student loans, the government wants to make it more affordable.  Since they can't control the cost of education, they can lower the cost of the student loans.

Since most student loans are subsidized or insured by the government, it doesn't hurt the government at all to give a little incentive to students.  Here's some math on the deduction.

The maximum student loan interest deduction is $2,500.  This means that you can lower your taxable income by $2,500.  If you're a recent grad at an entry level job, chances are you make about $40,000 per year.  You probably still rent an apartment, and don't have many investments.

To keep things simple, if you were debt free, you'd just get the standard deduction $5,950.  That means your taxable income for the year would be $34,050.  So, you would owe about $4,600 in taxes.

However, if you have student loan debt and have paid interest on the student loans, you get to claim up to $2,500 of interest paid.  So, instead of just the standard deduction, you'd get to add on an additional $2,500, bringing your total deduction to $8,450.  That would reduce your taxable income to $31,550.  With that extra deduction, you'd also lower your total tax due to $4,300.  That's a $300 savings.

Why It's a Scam

I mentioned above how the government is attempting to subsidize education and make it more affordable by offering this deduction.  However, a big side effect of this policy is that they are also incentivizing debt.  Instead of looking for ways to pay for school, the mantra is "go get student loans because your high paying job after graduation will make it easy to pay off".  But that just isn't the case anymore.

Last year, the average salary 10 years after graduation from an Ivy League school was $137,000.  Why 10 years?  That's how long it will take to pay off your loans on the standard repayment plan.  But $137,000 doesn't sound too bad, right?  That means you've probably earned close to $1,000,000 over those 10 years, and you probably took at $150,000 to $200,000 in student loans.

But what about the average student?  The average salary for a college graduate is only $46,000.  Depending on your major, your 10 year mid-career salary averages from that $46,000 to $96,000.  Now, imagine if you took out $100,000 in student loans?  Could you really afford to pay it back?

Now, ask yourself this - what is the student loan interest deduction really going to do for you to make college more affordable?  You may have thought you were going to get a break, only to find out you're in a heap of debt.

This is the key problem with deductions - it rewards debt (without regard for consequences), and punishes saving and fiscal responsibility.

In other words, if you paid for college in cash (either by saving money or working through school), you don't get any breaks from this deduction.  So, being smart and busting your ass gets you nothing, but taking on a heap of debt gets you a break?  Sounds like a scam to me.

Alternatives to Student Loan Debt

I've already extolled on the perils of student loan debt hundreds of times.  Heck, I wrote an eBook on it.  But since it is tax time, I want this to be a reminder that receiving a tax deduction for your debt, while nice, doesn't really help with the problem.

On the government side, it doesn't really help with education - costs keep rising, and students are just getting into trouble.  On the personal finance side, a few hundred dollars in savings is nice, but it doesn't make up for the thousands of dollars in interest you will pay, or the fact that you may have trouble repaying your student loans at all.

At the end of the day, the best thing to do is look for alternatives to student loan debt:

• Scholarships and Grants
• Employment
• Lower Cost Universities

And finally, just remember what your return on the investment will be.  Student loans are an investment in your own future, since what you make in the future will decide your ability to repay the debt.

What are your thoughts on incentivizing debt and punishing savers?  Does the student loan interest deduction make sense?